Interest rate risk is the risk that an investments value will alter due to fluctuations in the fixed level of interest rates, it is the risk to which a portfolio or institution is exposed because future interest rates are uncertain. It is, in a sense, a risk that an interest-earning asset will have their value declined due to the interest rates changing unpredictably. In this review, the object interest-earning asset is set to focus on loans.
Besides, these interest rates altercations are typically playing important roles in affecting securities contrarily. The risk can actually be reduced or mitigated, and this is done by diversification and sometimes hedging. And if the loan's maturity is long, in the sense of fixed rate loans, they are rather sensitive to price risk from the overall fluctuations in rates than variable rate loans.
The variability of interest rates poses great influence on the asset's value, the trend has never changed. But when the interest rate rises, new issues will appear in most markets with higher yields than older securities. This causes those older securities to worth lesser and this has proved that interest rates and asset value are moving in a reversed direction.
Through shifting the yield curve carefully, the interest rate risk can be understood better. However, not all loans have the same reaction when the interest rates changes. The lack of attention paid on the interest rate risk is proven to be fatal, where the portfolio risks are omitted or ignored by the investors. As with any risk management assessment, there is always the option to do nothing, and that is what many people do (Simon, 2009).
To meet the requirement of increasing the profit and more suitable returns for their stakeholders, many banks have lengthened asset maturities or increased assets with integrated electivity. So, if a loan reaches its maturity, the lesser the price will fluctuate, and this will significantly reduces the interest rate risks and market risks
As addendums, interest rate risk often have less affect on stock, however, the affects is much stronger on bonds value. As we know, high interest rate reflects low bond price. The reason is that as interest rates increase, the opportunity cost of holding a bond decreases, and the price of the bond must fall for the yield to match the new market rate. This is due to the ability of the investors to gain higher yields by changing investments that have higher interest rates. Some investors are normally confused by the inverse relationship between bonds and interest rates where the bonds worth less when interest rates rise.
Although interest rate risk cannot be completely eliminated, there are still some alternatives to reduce the risk. For example, interest rate risk can be hedged by using swaps and interest rate based derivatives. To control interest rate risk, investment in floating rate rather than fixed rate securities is more preferred due to the maturity in shorter. Besides, calculation of the net market value of the assets and liabilities is also another way to analyze interest rate risk.
So, in order to affirm the security of the price of the loans that is categorized as assets of most commercial banks, interest rate risk management has been taken into account by the people. Due to the huge impact of interest rate changes on the value of long-term financial assets and liabilities, so it could be a heavy price to bear if the interest rate risk is ever ignored. As the final reiteration, to meet the demands of their customers and communities and to execute business strategies, most of the banks make loans, purchase securities, and take deposits with different maturities and interest rates. These activities may leave a bank's earnings and capital exposed to movements in interest rates. Once again, this exposure is defined as interest rate risk (Interest Rate Risk, 1997).
(b) Literature review
After the crisis of Savings and Loan (S&L), the number of banks that concerned with interest rate risk had been increasing over. According to Alessandri and Drehmann (2010), the most important risk that determines the economic capital of a bank is credit risk while interest rate risk is second. When a bank realized that the current interest rate is low, this may drive up the intention to engage in higher risk activities. This statement has been supported by relevant evidence like Dell'Ariccia and Marquez (2006), Rajan (2006), Borio and Zhu (2008). All these authors concluded that a bank will engage in risk taking activities under a low interest rate environment.
When the numbers of risk taking activities are growing in the bank, this will increase the bank's exposure to interest rate thus increasing the interest rate risk. Risky activities like long term loans within or outside the country will increase the proportion of interest rate risk, this is because the massive changes in interest rate will lead to violation of repayment of debt. According to Delis and Kouretas (2011), a bank can have higher profits if acquired a relatively high level of risk assets and these high profits may be used in getting new loans in future. However, the authors added that excess risks will lead to critical situation and lowers down the profitability. From these explanations, we can see that there is a link between profitability and interest risk rate which an optimal interest rate risk will lead to high profits of a bank.
There are a large amount of banks facing bankruptcy between 1976 and 1981 due to the excessive interest rate risk which used deposits (short term liability) to offer the home loan (long term assets). These statements were mentioned in the article of Zhu, Hassan and Li (2007) that claimed that over exposure of interest rate will lower down the profitability and force a bank into bankruptcy. The impact of interest rate risk should never be underestimated by a bank because interest rate risk is the main factor for the banks to suffer in insolvency whereby the banks are not able to meet the obligation of paying interest that is promised.
The situation can be more even worse that the banks will be bankrupt if the payment is defaulted and this is the micro view for the impact of the interest rate risk. For the macro view of interest rate risk, it can be rather serious since it will affect the economy as a whole. At the same time, the bankruptcy of banks might causes a lot of damages to the health of the economy and slows down the growth of economy thus lowers the standards of living in the country.
After studying the impacts of interest rate risk, we can see that the risk plays an important role in a bank. The success and failure of a bank are depending on how well the management of exposure to interest rate risk. As we have mentioned earlier, Delis and Kouretas (2011) claimed that interest rate risk is important to reflect the profitability of a bank. Well managed of interest rate risk will lead to a high profitability while excess risk and lack of monitoring will lower down the profitability and lead to a bankruptcy.
Nowadays, there are massive of literature studying about interest rate risk management in order to increase the awareness of interest rate risk. According to Yang et al. (2010), interest rate swap is a popular way to reduce the risk of fluctuations in interest rate. Previously, people create interest rate swap with the objective of decreasing the cost of borrowing for fixed or floating rate markets. With the dynamic and uncertain environment of economy, banks, company and even individual starting to hedge against the changes in interest rate by using interest rate swaps.
Beside interest rate swap, Sierra and Yaeger (2004) recommended some other ways to respond to interest rate risk. These ways are more concern in the internal control of the banks, by providing capital market training for the bank examiners in order to increase their understanding in the way of measuring and managing interest risk is one of the ways suggested. Examiners with adequate trainings will be able to make accurate and efficient decision which related to interest rate. The author added that there is a measurement of interest rate risk developed to enable examiners to analyze the scope of risk, this measurement called the Economic Value Model (EVM). This model is developed by the Economists of Federal Reserve System and with the objective of measuring the sensitivity of banks in term of interest rates.
Theoretically, banks should be able to overcome the interest rate risk and increase profitability by using the above measurement. However, numbers of banks bankrupted in recent years still in an increasing trend which causes a lot of unfavorable result for the economy. The explanation for this situation is there are many banks have ignored the interdependence relationship between credit risk and interest rate risk. Jarrow and Turnbull (2000) are the minority who showed the relationship between credit risk and interest risk with factor modeling approach. The authors also stated that, "Economic theory tells us that market and credit risk are intrinsically related to each other and not separable" (p. 271).
There is not only relationship between credit and interest risk but there is also significant interaction between both risks (Drehmann, Sorensen & Stringa, 2010). If we try to ignore either one risk, the researchers showed that there will be a massive drop in the profits of a bank which may greater than 50%. Sometimes the situation will be more even worse if the risks do not being well managed jointly. These results show that credit risk and interest risk are interrelated and cannot be measured separately. Indirectly, we can form a statement that a well risk assessment need to have a combined consideration of credit risks as well as interest rate risks.
Arguments of Inconsistency
However, in the process of literature review, we found that the article written by Siera and Yaegar in 2004 has inconsistence evidence with the article of Drehmann, Sorensen and Stringa (2010). Sierra and Yaeger (2004) have concluded that their researches have failed to prove the interaction between the credit risks and interest rate risks. In addition, they even pointed out that interest rate risk is not significant enough to affect the bank safety and soundness.
The inconsistency of the result shown by both article can be explained through the way of collecting data or methodology. Sierra and Yaeger (2004) carried out that the researches by using the data from 1998 to 2002 and this would affect the accuracy of the result. This is because Asian Financial Crisis hit Asia countries and gives some collateral damages to the Europe countries. This means that majority of the banks are affected during that period and might still in the process of recovery between the time period of 1998 to 2002. Thus, the collection data period will be the reason for inconsistent result of both articles.
Besides, both data analyzed by the authors are different from each others. Sierra and Yaeger (2004) mentioned that their data is focus on the assets of the banks and this is different from Drehmann, Sorensen and Stringa (2010) since they are analyzing on the banks' assets, liability, equity and the off-balance sheet items. The researches by Drehmann, Sorensen and Stringa (2010) will be more convincing since they have considered more items than the other authors.
From the differences of data collected and time period, we can see that Drehmann, Sorensen and Stringa (2010) ways of doing researches are more convincing than the others. Therefore, we have enough evidence to prove that there is significant interaction between credit risks and interest rate risks and it is crucial to measure them jointly.
(c) Recommendations and Conclusion
In order to reduce the interest rate risk, there are few interest rate derivative instruments can be used to manage the interest rate risk. Firstly, by entering a forward contract, an agreement where two parties agreed to buy or sell an asset at a certain future time for a certain price upon today. Forward Rate Agreements (FRAs) is paid in cash form and is developed based on the idea of a forward contract whereby interest rate is used to determine profit or loss. The current interest rate level can be hedged for a future investment by selling FRA and it will return a profit if the interest rates drop by the time when the investment is made.
Next, a futures contract is between two parties with an intermediary involved, thus less risky in terms of default and liquidity compared to forward contract. One of the parties is required to agree and make delivery of a commodity or financial asset and the other party to accept delivery of the same commodity or financial asset.
Besides, swaps is an agreement to exchange cash flows at specified future times according to certain specified rules. In the swapping process, one party pays a fixed interest rate and receives a floating rate and the other party pays a floating rate and receives a fixed rate, it is also known as plain vanilla swap. The interest rate swap is mainly used for Asset and Liability Management (ALM), the management of large credit or asset portfolios. If interest rate changes are expected loans cannot always simply be switched. However, it is limited to the interest rate difference as capital is not exchanged.
An option contract is useful in floating rate loan such as adjustable-rate mortgages (ARMs). Option contract is where underlying security is a debt obligation and grouped into interest rate caps and interest rate floors. A floor is used to hedge investments against falling interest rates. Customers earn profit if interest rates increase and the banks pay the customer the difference between the agreed exercise price and the market interest rate if the rates drop. A premium is needed for this option and falling interest is hedge while we continue to profit from stable or rising interest rates. This alternative is normally used by lender to protect against falling rates on an outstanding floating-rate loan. Meanwhile, a cap, also known as ceiling is a call option on an interest rate which is also the mirror of the floor.
In addition, purchase the Treasury Inflation Protected Securities (TIPS) can help to protect the investors against inflation by increasing the principal of the bond regarding with the inflation rate which measured by the Consumer Price Index (CPI). Because the interest rate is fixed, so the principal value of the bond will increase, so does the amount of interest paid. When inflation raises generally the interest rates also will rise, TIPS can help to manage the interest rate risk by increasing the value principal and interest.
In conclusion, it has been long time recognized that a firm will exposure to interest rate risk depends on the assets and the liabilities on its balance sheet and the volatility of interest rate. The interest rate risk on a firm can be complex, but a clear business and financial strategy will put interest rate risks in context because it can help a firm to achieve its goals. It is therefore not only important for the banks forecast interest rate risks but also to measure and manage it appropriately. By using derivatives can thus be considered as a part of any bank's interest rate risk management strategy and also its total risk management strategy to ensure optimal financial performance (Beets, 2004).
